FRANCHISE RULE 16 C.F.R. Part 436 COMPLIANCE GUIDE

Transcription

1 FRANCHISE RULE 16 C.F.R. Part 436 COMPLIANCE GUIDE May 2008

2 INTRODUCTION This Compliance Guide is intended to help franchisors comply with the Federal Trade Commission s amended Franchise Rule. The original Franchise Rule went into effect on October 21, The Federal Trade Commission ( FTC or the Commission ) approved amendments to the Franchise Rule on January 22, Since July 1, 2007, franchisors could comply with the FTC s disclosure requirements by using any one of the following formats: (1) the original Franchise Rule; (2) the Uniform Franchise Offering Circular ( UFOC ); or (3) the amended Franchise Rule. Once a franchisor selects a disclosure format, it must use that format and no other. As of July 1, 2008, however, all franchisors must use only the amended Franchise Rule. This Guide does not modify the amended Rule. It explains the requirements of the amended Rule. Moreover, it does not exhaustively cover every requirement contained in the amended Rule, but focuses on amended Rule provisions that depart from the familiar UFOC Guidelines. This Guide also includes sample disclosures that illustrate the new provisions and will be useful in preparing compliant disclosures. There is no substitute for the text of the amended Rule. It is the authoritative statement of what franchisors need to do to comply. Thus, the amended Rule s text along with its explanatory Statement of Basis and Purpose is the starting point and ultimate authority in preparing compliant disclosures. This Guide is an additional resource, representing the FTC staff s view of what the law requires. This Guide will be updated periodically as new interpretive issues arise. Other important resources for compliance guidance are the Amended Franchise Rule FAQ s on the FTC s web site at and staff opinions that have been issued in response to specific requests regarding particular fact situations. The staff opinions can be found at

3 The advice in this Guide is not binding on the Commission. In addition, the original Rule s Statement of Basis and Purpose and previous informal staff advisory opinions remain valid sources of interpretation, except to the extent of any conflict with the amended Rule s requirements. Like the original Franchise Rule and the UFOC Guidelines, the amended Rule requires franchisors to give prospective franchisees material information, including background information on the franchisor, the costs of entering into the business, the legal obligations of the franchisor and the franchisee, statistics on franchised and company-owned outlets, and audited financial information. In addition, if franchisors elect to make any financial performance representations, the amended Franchise Rule requires certain disclosures and substantiation for those representations. For the most part, these disclosures are based upon the UFOC Guidelines, with which many franchisors and practitioners are already familiar. As outlined below, the amended Rule differs from the UFOC Guidelines (and the original Rule) in several respects. First, the amended Rule updates the UFOC Guidelines to address new technologies, like the Internet. Second, the amended Rule requires more disclosure about the nature of franchisor-franchisee relationships. The amended Rule includes several disclosure requirements not included in the UFOC Guidelines. Also, the Amended Rule exempts certain entities that the original Rule did not exempt, and prohibits certain practices not addressed in the original Rule. -ii-

4 TABLE OF CONTENTS Franchise Rule Coverage...1 What Types of Relationships Are Covered...1 The Trademark Element...2 The Significant Control or Assistance Element When Is Control or Assistance Significant What Activities Do Not Constitute Significant Control or Assistance The Required Payment Element...4 What Types of Payments Constitute Required Payments What Types of Payments Do Not Constitute Required Payments What Types of Relationships Are Not Covered Business Opportunities....6 Sales of Franchises to Be Located Outside of the United States and its Territories What Types of Relationships Are Exempt...7 Minimum Payment Exemption...7 Fractional Franchise Exemption....8 Whose Experience May Be Considered What Does Same Line of Business Mean How Is Sales Volume Calculated...8 Leased Department Exemption...9 Oral Agreements....9 Petroleum Marketers and Resellers Exemption Large Franchise Investment Exemption What Is an Initial Investment...10 Do Conversion Franchises and Transfers Qualify for the Exemption Who Must Make the Initial Investment What Is the Acknowledgment Requirement Large Franchisee Exemption...12 What Type of Business Experience Is Required How Is Net Worth Determined May the Experience and Net Worth of Parent and Affiliate Companies Be Considered The Insiders Exemption...13 Exclusions from the Amended Rule Employer-employee Relationship Exclusion General Partner Relationship Exclusion Cooperative Associations Exclusion...16 Certification or Testing Services Exclusion Single Trademark License Exclusion iii-

5 Compliance with Disclosure Obligations Who Is Responsible for Preparing Disclosure Documents Who Is Responsible for Furnishing Disclosure Documents What Happens When an Existing Franchisee Sells His or Her Outlet What Happens When an Existing Franchisee Purchases Additional Outlets Ways of Furnishing Disclosure Documents Are There Any Specific Requirements for Electronic Disclosures Is Electronic Disclosure Permitted for All Franchisors as of July 1, At What Point in the Sales Process Must a Franchisor Furnish the Disclosure Document Payment to or Binding Agreement with the Franchisor or Affiliate Actions That Constitute the Furnishing of Disclosure Documents Opportunity for Prospective Franchisees to Review the Franchise Agreement Unilateral Material Modifications by the Franchisor Unilateral Material Modifications by the Franchisee The Disclosure Document...24 The Cover Page...24 Reference to Item 5 and Item 7 Fees and Investment Available Disclosure Formats...25 Issuance Date...26 Inclusion of State Information on the Cover Page Sample Cover Page The Table of Contents...27 Sample Table of Contents...28 Item 1: The Franchisor and Any Parents, Predecessors, and Affiliates Franchisor Disclosures...29 Agent for Service of Process Disclosure Parent Disclosures...29 Predecessor Disclosures...30 Principal Business Address Disclosure Applicable Government Regulations Disclosure Sample Item Item 2: Business Experience...33 Sample Item Item 3: Litigation What Types of Litigation Must Be Disclosed Pending Actions...35 Material Actions Involving the Franchise Relationship Prior Actions Injunctive Actions...38 Whose Litigation Must Be Disclosed Chart of Whose Actions Must Be Disclosed Sample Item iv-

6 Item 4: Bankruptcy...42 Sample Item Item 5: Initial Fees Uniformity of Fees Disclosure...43 Refunds Installment Payments...44 Sample Item Sample Item Item 6: Other Fees...45 Sample Item Item 7: Estimated Initial Investment...48 Sample Item Item 8: Restrictions on Sources of Products and Services Required Purchases of Goods and Services Optional Purchases...52 Approval of Alternative Suppliers...52 Ownership Interest in a Supplier...53 Revenue Derived from a Supplier Payments to Third Parties Benefits Extent of Required Payments...54 Aggregate Reporting Cooperatives Negotiated Prices...55 Sample Item Item 9: Franchisee s Obligations Sample Item Item 10: Financing Financing Agreements...60 Interest Rate...60 Variable Rates...61 Sample Item Item 11: Franchisor s Assistance, Advertising, Computer Systems, and Training Required Statement about the Limited Extent of the Franchisor s Obligation to Furnish Assistance Pre-Opening Assistance...64 Continuing Assistance...64 Optional Assistance...65 Advertising Assistance...65 Multiple Brand Advertising...65 Allocation of Production and Administrative Expenses Computer Systems...66 Operating Manuals...67 Training v-

7 -vi- Sample Item Item 12: Territory...72 Sample Item Item 13: Trademarks...74 Sample Item Item 14: Patents, Copyrights, and Proprietary Information Sample Item Sample Item Item 15: Obligation to Participate in the Actual Operation of the Franchise Business.. 78 Sample Item Sample Item Item 16: Restrictions on What the Franchisee May Sell Sample Item Item 17: Renewal, Termination, Transfer, and Dispute Resolution Discretionary Benefits...80 Renewals...81 Sample Item Item 18: Public Figures...83 Who Qualifies as a Public Figure...84 Use of Name, Image, or Endorsement...84 Management...84 Investment...84 Sample Item Item 19: Financial Performance Representations Required Item 19 Preambles...85 Financial Performance Representations: Historical or Projected Historic Performance...87 The Group Measured...87 Did All Outlets in the System, or Only Some of Them, Achieve the Stated Level of Performance Are the Outlets Measured Franchised Outlets, Company-owned or Outlets of an Affiliated System with Similar Operations Time Period Measured...88 When Was the Stated Level of Performance Achieved Number of Outlets Measured...89 How Many Outlets Are in the Group That Achieved the Stated Level of Performance, and How Many Are in the Entire System Number of Outlets Reporting...89 How Many Outlets in the Relevant Group Supplied the Performance Data Underlying the Representation

8 Number and Percentage of Outlets that Achieved the Stated Level of Performance What Proportion of the Group Measured Achieved the Results Claimed...90 Distinguishing Characteristics...90 What Are the Common Attributes of the Outlets That Achieved the Stated Level of Performance Projected Performance...91 Admonition Availability of Substantiation Financial Performance Representations on a Specific Outlet Offered for Sale...93 Supplemental Representations...93 Sample Item Sample Item Item 20: Outlets and Franchisee Information Statistical Information...95 Definitions Used in Item General Instructions for Preparing Item 20 Tables ` Multiple Events Affecting the Status of a Particular Franchise Outlet Table No. 1 Systemwide Outlet Summary Sample Item 20-1 (Table 1)...98 Table No. 2 Summary of Transfers...98 Sample Item 20-2 (Table 2)...99 Table No. 3 Summary of Status of Franchisee-Owned Outlets Multiple Owners Sample Item 20-3 (Table 3) Table No. 4 Summary of Status of Company-Owned Outlets Sample Item 20-3 (Table 4) Table No. 5 Projected New Outlets (Both Franchised and Company-Owned).101 Outlets Signed but Not Opened Projected Franchised and Company-Owned Outlets Sample Item 20-5 (Table 5) Contact Information for Current Franchisees Contact Information for Former Franchisees Sample Item 20-6 (Former Franchisees) Previous Owner Information Sample Item 20-7 (Previous Owners) Confidentiality Agreements What Constitutes a Confidentiality Agreement vii-

9 What about Clauses Designed to Protect Trademarks or Other Proprietary Information Optional Additional Disclosures Sample Item 20-8 (Confidentiality Agreements) Franchisee Associations Associations Created, Sponsored, or Endorsed by the Franchisor Independent Franchisee Associations Organized under State Law Request for Inclusion Annual Renewal Sample Item 20-9 (Franchisee Associations) Item 21: Financial Statements GAAP Requirement Parent Financial Information Affiliate Financial Information Subfranchisor Financial Information Phase-In of Audited Financial Statements Sample Item Sample Item Item 22: Contracts Sample Item Item 23: Receipts Required Preamble Name of Seller Issuance Date Return of Receipt Sample Item Instructions for Preparing Disclosure Documents Use of Plain English Single Document Disclosures Must Address Each Disclosure Item No Additional Information State Requirements Electronic Disclosures Multi-State Disclosures Subfranchisors Statement of Prerequisites To Reviewing A Disclosure Document Sample Advisory on Disclosure Document Format, Prerequisites, and Conditions Recordkeeping viii-

10 Instructions for Updating Disclosures Annual Updating Requirement Quarterly Updating Requirement Relationship Between Annual and Quarterly Updates Prospective Franchisee s Right to Obtain Updated Disclosures and Any Quarterly Updates When is a Request Reasonable How Long After Updates Before Signing the Franchise Agreement Material Changes Relating to Financial Performance Representations Financial Performance Representations What Constitutes a Financial Performance Representation Does Cost Information Constitute a Financial Performance Representation General Media Representations Do Statements in Speeches and Press Releases Constitute General Media Representations What about Statements in SEC filings Do They Constitute General Media Representations Specific Requirements Applicable to General Media Claims Relationship Between General Media Financial Performance Representations and Item 19 Disclosures Sample General Media Financial Performance Representation Reasonableness of a Financial Performance Representation Financial Performance Representations Based on Projections Financial Performance Representations Based on Historic Performance Substantiation of Financial Performance Representations Inclusion of Financial Performance Information in Item Availability of Written Substantiation for Financial Performance Representations Additional Prohibitions Prohibition Against Contradictory Information Prohibition Against Use of Shill Testimonials Prohibition Against Failing to Make Requested Early Disclosures Prohibition Against Failing To Furnish Updated Disclosures Prohibition Against Failing To Note Unilateral Modifications Prohibition of Disclaimers and Waivers Scope of the Prohibition Parties Ability to Negotiate Contracts Terms Alternatives to Disclaimers and Waivers Sample Integration Provision Prohibition Against Failing to Make Promised Refunds Franchisors Rights to Regulatory Enforcement Fairness ix-

11 FRANCHISE RULE COVERAGE Whether the Franchise Rule applies to a particular business relationship depends upon whether the relationship meets the Rule s definition of a franchise and whether an exemption or exclusion applies. WHAT TYPES OF RELATIONSHIPS ARE COVERED? The amended Rule covers the offer and sale of franchises. As under the original Rule, a commercial business arrangement is a franchise if it satisfies three definitional elements. Specifically, the franchisor must: (1) promise to provide a trademark or other commercial symbol; (2) promise to exercise significant control or provide significant assistance in the operation of the business; and (3) require a minimum payment of at least $500 during the first six months of operations. Like the original Rule, the amended Rule covers business format and product franchises. The name given to the business arrangement is irrelevant in determining whether it is covered by the amended Rule. A business arrangement described as a franchise will not be covered unless it meets the three definitional elements in the amended Rule. In the same vein, a self-described distributorship will be covered by the amended Rule only if the three definitional elements are satisfied. Further, the amended Rule covers relationships that are represented either orally or in writing as having the characteristics specified in the amended Rule s definition of franchise, regardless of whether the representations are, in fact, true or can be fulfilled. Accordingly, if a seller of a business arrangement represents that it licenses its trademark, promises to provide significant assistance in the buyer s business operations, and charges a minimum payment of at least $500, the arrangement will be covered by the Rule even if, for example, the seller, in fact, has no trademark or has no means to provide any assistance to buyers.

12 The Trademark Element A franchise entails the right to operate a business that is identified or associated with the franchisor s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor s trademark. The term trademark is intended to be read broadly to cover not only trademarks, but any service mark, trade name, or other advertising or commercial symbol. This is generally referred to as the trademark or mark element. The franchisor need not own the mark itself, but at the very least must have the right to license the use of the mark to others. Indeed, the right to use the franchisor s mark in the operation of the business either by selling goods or performing services identified with the mark or by using the mark, in whole or in part, in the business name is an integral part of franchising. In fact, a supplier can avoid Rule coverage of a particular distribution arrangement by expressly prohibiting the distributor from using its mark. The Significant Control or Assistance Element The amended Rule covers business arrangements where the franchisor will exert or has the authority to exert a significant degree of control over the franchisee s method of operation, or provide significant assistance in the franchisee s method of operation. When Is Control or Assistance Significant? The more franchisees reasonably rely upon the franchisor s control or assistance, the more likely the control or assistance will be considered significant. Franchisees reliance is likely to be great when they are relatively inexperienced in the business being offered for sale or when they undertake a large financial risk. Similarly, franchisees are likely to reasonably rely on the franchisor s control or assistance if the control or assistance is unique to that specific franchisor, as opposed to a typical practice employed by all businesses in the same industry. Further, to be deemed significant, the control or assistance must relate to the franchisee s overall method of operation not a small part of the franchisee s business. Control or assistance involving the sale of a specific product that has, at most, a marginal effect on a -2-

13 franchisee s method of operating the overall business will not be considered in determining whether control or assistance is significant. Significant types of control include:! site approval for unestablished businesses;! site design or appearance requirements;! hours of operation;! production techniques;! accounting practices;! personnel policies;! promotional campaigns requiring franchisee participation or financial contribution;! restrictions on customers; and! locale or area of operation. Significant types of assistance include:! formal sales, repair, or business training programs;! establishing accounting systems;! furnishing management, marketing, or personnel advice;! selecting site locations;! furnishing systemwide networks and website; and! furnishing a detailed operating manual. To a lesser extent, the following factors will be considered when determining whether significant control or assistance is present in a relationship: -3-

14 ! a requirement that a franchisee service or repair a product (except warranty work);! inventory controls;! required displays of goods; and! on-the-job assistance with sales or repairs. What Activities Do Not Constitute Significant Control or Assistance? Promotional activities, in the absence of additional forms of assistance, will not be deemed significant. This includes furnishing a distributor with point-of sale advertising displays, sales kits, product samples, and other promotional materials intended to help the distributor in making sales. It also includes providing advertising in such media as radio and television, whether provided solely by the franchisor or on a cooperative basis with franchisees. In addition, the following items do not constitute significant control or assistance, as a 1 matter of Commission policy :! trademark controls designed solely to protect the trademark owner s legal ownership rights in the mark under state or federal trademark laws (such as display of the mark or right of inspection);! health or safety restrictions required by federal or state law or regulations;! agreements between a bank credit interchange organization and retailers or member banks for the provision of credit cards or credit services; and! assisting distributors in obtaining financing to be able to transact business. The Required Payment Element The last of the three definitional elements of a franchise covered by the amended Rule is that purchasers of the business arrangement must be required to pay to the franchisor (or to an affiliate), as a condition of obtaining a franchise or starting operations, a sum of at least $500 at 1 See Original Interpretive Guides, 44 Fed. Reg. 49,966, at 49,967 (Aug. 24, 1979). -4-

15 any time prior to or within the first six months of the commencement of operations of the franchised business. What Types of Payments Constitute Required Payments? Payment is intended to be read broadly, capturing all sources of revenue that a franchisee must pay to a franchisor or its affiliate for the right to associate with the franchisor, market its goods or services, and begin operation of the business. Often, required payments go beyond a simple franchisee fee, entailing other payments that the franchisee must pay to the franchisor or an affiliate by contract including the franchise agreement or any companion contract. Required payments may include:! initial franchise fee;! rent;! advertising assistance;! equipment and supplies (including such purchases from third parties if the franchisor or its affiliate receives payment as a result of the purchase);! training;! security deposits;! escrow deposits;! non-refundable bookkeeping charges;! promotional literature;! equipment rental; and! continuing royalties on sales. Payments which, by practical necessity, a franchisee must make to the franchisor or affiliate also count toward the required payment. A common example of a payment made by -5-

16 practical necessity is a charge for equipment that can only be obtained from the franchisor or its affiliate and no other source. What Types of Payments Do Not Constitute Required Payments? The payment element of the franchise definition does not include payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or 2 lease. Reasonable amounts means amounts not in excess of those that a reasonable businessperson normally would purchase for a starting inventory or supply, or to maintain an ongoing inventory or supply. This inventory exemption also includes goods intended to be furnished to the public through lease. Thus, franchisees such as those in the auto or furniture rental business can take advantage of this inventory exemption. The inventory exemption, however, does not include goods that a franchisee must purchase for its own use in the operation of the business, such as equipment or ordinary business supplies. WHAT TYPES OF RELATIONSHIPS ARE NOT COVERED? As discussed in the Statement of Basis and Purpose, the amended Rule no longer covers the sale of business opportunity ventures. It also does not cover the sale of franchises to be located outside of the United States and its territories. Business Opportunities Disclosure requirements and prohibitions pertaining to business opportunities are now set forth in a separate Rule 16 C.F.R. Part 437. At present, Part 437 is substantively identical to the disclosure requirements and prohibitions set forth in the original Franchise Rule. The Commission, however, is contemplating amending Part 437, and there is an ongoing rulemaking on that issue. 2 For background information on the reasons for the inventory exemption, see Original Interpretive Guides, 44 Fed. Reg. at 49,

17 Sales of Franchises to Be Located Outside of the United States and its Territories As a matter of policy, the amended Rule reaches only the offer or sale of franchises to be located in the United States and its territories. Accordingly, the amended Rule does not apply, for example, to the sale of a franchise to an American citizen living in Paris (or in Chicago), or to a French citizen in Paris, when the outlet will be located in Europe. 3 WHAT TYPES OF RELATIONSHIPS ARE EXEMPT? Some business arrangements satisfying the three definitional elements of the term franchise nonetheless may be exempt from the amended Franchise Rule. First, the amended Rule retains each of the exemptions found in the original Rule: the minimum required payment, fractional franchise, leased departments, and oral agreements exemptions. Second, the amended Rule adds new exemptions for sales governed by the Petroleum Marketing Practices Act, and for certain sales involving sophisticated investors. Minimum Payment Exemption Exempt from the Franchise Rule are franchise sales where the total of the required payments, or commitments to make a required payment, to the franchisor or an affiliate that are made any time from before to within six months after commencing operations of the franchisee s 4 business is less than $500. A franchisee commences operation when it first makes goods or services available for sale. A commitment entered into during the first six months that requires a payment later than six months after commencing operation (such as a promissory note or that portion of lease payments made after six months) is not counted toward the $500 minimum. 3 Limitation of the geographic scope of the amended Franchise Rule is not intended to limit the FTC s jurisdiction, as it is set forth in section 5(a) of the FTC Act, 15 U.S.C. 45(a), and section 3 of the U.S. SAFE WEB Act of 2006, Pub. L. No , 120 Stat The Commission may adjust the $500 threshold and all other monetary thresholds found in the Rule s exemptions every four years for inflation. -7-

18 Fractional Franchise Exemption The amended Rule exempts the sale of fractional franchises. A fractional franchise relationship is created when the following two elements are present at the start of the relationship:! The franchisee, any of the franchisee s current directors or officers, or any current directors or officers of a parent or affiliate, has more than two years of experience in the same type of business; and! The parties have a reasonable basis to anticipate that the sales arising from the relationship will not exceed 20% of the franchisee s total dollar volume in sales during the first year of operation. Whose Experience May Be Considered? The amended Rule expands the original Rule s list of individuals whose prior experience will satisfy the first element to include current directors or officers of a parent or affiliate. The experience of directors or officers of a parent or an affiliate may be considered, so long as those individuals prior experience has been in the same line of business. What Does Same Line of Business Mean? Same line of business means selling competitive goods, or being in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise. Accordingly, an independent ice cream store owner might qualify as a fractional franchisee if he or she were to enter into a franchise relationship with an ice cream cake supplier. However, the ice cream store owner would probably not qualify as a fractional franchisee if he or she were to enter into a franchise relationship to expand the product line to include items not typically found in ice cream stores, like greeting cards. How Is Sales Volume Calculated? When considering the second required element whether increased sales volume from the fractional franchise relationship exceeds 20% of total sales the parties may measure incremental sales resulting from the fractional franchise against total sales at all stores owned by -8-

19 the franchisee (franchised or non-franchised). For example, an individual owning several hardware stores may introduce a new product at one store only. The store owner should measure the increase in sales attributed to the new product against the aggregate total sales volume for all products sold through his or her businesses. Leased Department Exemption Like the original Rule, the amended Rule exempts leased department arrangements. A leased department is an arrangement in which an independent retailer sells its own goods and services from premises leased from a larger retailer in the larger retailer s store. These arrangements usually occur in the merchandising of footwear, optometry, tobacco, cosmetics, and jewelry. For example, a jeweler may rent space from a department store to sell jewelry and watches. Technically, this relationship may be a franchise because the jeweler becomes associated with the department store s trademark, and the department store may impose what arguably could be considered significant control over the operation, like operating hours. This exemption is available only if the independent retailer is not required directly or indirectly to purchase its goods or services from either the larger retailer or from suppliers required or approved by the larger retailer. Oral Agreements The amended Rule exempts purely oral relationships that lack any written evidence of a material term of the franchise relationship or agreement, as a matter of policy, to avoid problems of proof in its enforcement. However, the exemption does not apply when there is any writing, even if unsigned, with respect to a material term, such as a purchase invoice for goods or equipment. Petroleum Marketers and Resellers Exemption The amended Rule expressly exempts petroleum marketers and resellers covered by the Petroleum Marketing Practices Act ( PMPA ). The most common types of franchises falling under this exemption are gasoline station franchises. -9-

20 The PMPA exemption is intended to be read broadly. It covers not only gasoline stations, but other services and products such as a repair center, car wash, or convenience store sold to a prospective franchisee under the same, unified, franchise agreement as the gasoline station itself. However, the offer or sale of a convenience store or other franchise to an existing gasoline station franchisee under a separate franchise agreement is not exempt, and is, in fact, no different from the ordinary sale of a franchise to an existing franchisee. Large Franchise Investment Exemption The amended Rule exempts franchise offers and sales where the initial investment is at least $1 million, excluding the cost of unimproved land and any franchisor (or affiliate) 5 financing. In addition, the prospective franchisee must sign an acknowledgment that the franchise sale is exempt from the Franchise Rule because the prospective franchisee will be making an initial investment of at least $1 million. What Is an Initial Investment? A franchisee s initial investment is limited to the type of expenses that would ordinarily appear in an Item 7 disclosure expenses paid through the opening of the outlet and any additional expenses paid through the three-month initial period thereafter. It does not reach all possible payments to the franchisor made over the life of the franchise agreement. Accordingly, future obligations to pay rent, royalties, or advertising fund contributions to be made over the life of the franchise agreement do not count toward the initial investment. The initial investment 6 also does not reach costs associated with unimproved land, nor any funds obtained through franchisor (or affiliate) financing. 5 As noted previously, the Commission may adjust the large investment threshold every four years for inflation. 6 In determining whether the threshold is met, the cost of buildings, fixtures, equipment, and other improvements to the land may be included, but not the unimproved land itself. -10-

21 Further, the exemption focuses on the level of the initial investment, not on the number of outlets or the type of outlets being sold. Accordingly, the exemption will apply where the total projected initial investment is reached, whether for a single unit or multiple units. At the same time, it is possible that the large investment exemption may apply to some, but not all, of a franchisor s franchise sales. For example, a fast-food restaurant franchisor may sell stand-alone, full facility restaurant franchises for an initial cost of $1 million, while at the same time selling kiosks for a much reduced price, such as $100,000. Under the circumstances, only the sale of the stand-alone restaurants would qualify for the exemption. Do Conversion Franchises and Transfers Qualify for the Exemption? Conversion franchises and transfers of franchised outlets may qualify for the large investment exemption. In a conversion franchise, a business owner has already invested in his or her existing business and now seeks to associate with a particular franchisor s mark by entering into a franchise agreement with that franchisor. When considering a conversion franchisee s initial investment in a franchise, the conversion franchisee s previous investment in the outlet (as opposed to the current value of the outlet) may be considered. This is true even though the conversion franchisee s initial investment was not paid to the franchisor making the current offer. In a transfer, a prospective franchisee buys an existing franchise directly from an existing franchisee, but then may enter into a new franchise agreement with the franchisor. The fact that a transferee will assume an existing contract or may renegotiate an existing contract with the franchisor ordinarily has no bearing on his or her level of sophistication as an investor. As long as he or she satisfies the monetary threshold, the large investment exemption is available. As in the case of the conversion franchisee, the prior investment to a party other than the franchisor here, the transferring franchisee does not preclude application of the large investment exemption. -11-

22 Who must Make the Initial Investment? Where an investor group seeks to purchase a franchise, at least one individual must invest at the $1 million level for the exemption to apply. The large investment exemption is premised on the assumption that a franchisee s ability to pay a large sum equates with sophistication. That assumption fails when no one investor standing alone is investing at the requisite threshold level. For purposes of this provision, a husband and wife can be considered a single individual since their assets are typically commingled. What Is the Acknowledgment Requirement? To take advantage of the large investment exemption, franchisors must obtain from the prospective franchisee a signed acknowledgment that the investment satisfies the $1 million threshold. The acknowledgment must contain the following prescribed statement: The franchise sale is for more than $1 million excluding the cost of unimproved land and any financing received from the franchisor or an affiliate and thus is exempt from the Federal Trade Commission s Franchise Rule disclosure requirements, pursuant to 16 C.F.R (a)(5)(i). While the amended Rule does not specify the exact format of the acknowledgment the acknowledgment must be clear and conspicuous and in plain English, consistent with the Rule s general directions, and the franchisor has the burden to prove that the acknowledgment was furnished to, and signed by, the prospective franchisee. Large Franchisee Exemption The amended Franchise Rule exempts franchise offers and sales to large entities such as airports, hospitals, and universities that have been in business for at least five years and have a 7 net worth of at least $5 million. 7 As with the minimum required payment and large investment thresholds noted above, the Commission may adjust the threshold for the large franchisee exemption currently set at $5-12-

23 What Type of Business Experience Is Required? To qualify for the exemption, the large entity must have five years of prior business experience. That experience, however, need not be in franchising, or even in the franchised business in particular. For example, a hospital seeking to purchase a flower shop franchise could qualify for the exemption, even though the hospital may not have any prior experience with franchising or with the flower industry. How Is Net Worth Determined? To qualify for the large franchisee exemption, the prospective franchisee-entity must have a net worth of $5 million. The net worth of an entity can readily be determined from the entity s balance sheet or other financial information, typically submitted as part the application process. May the Experience and Net Worth of Parent and Affiliate Companies Be Considered? When determining the prior experience and net worth of a franchisee-entity, franchisors may consider the prior experience and net worth of the prospective franchisee s affiliates and parents. For example, a franchisor such as a hotel may wish to establish a separate corporation for a particular transaction. It is possible, however, that the new spin-off corporation will meet neither the net worth nor prior experience prerequisites. The amended Rule makes clear that the prior experience and net worth of the parent may be considered in such circumstances. Accordingly, franchisors may aggregate commonly-owned franchisee assets in determining the availability of the large entity exemption. The Insiders Exemption The amended Rule adds a new exemption for franchise sales to the officers, directors, general partners, managers (collectively officers ), and owners of a franchisor. The prerequisites to qualify for this exemption differ depending upon whether the individual million every four years for inflation. -13-

24 franchise purchaser is an officer, director, general partner, or manager, on the one hand, or an owner, on the other. To take advantage of the exemption, an officer must seek to purchase at least a 50% ownership interest in the franchise being offered for sale. In addition, the officer must have at least two years of experience with the franchisor as an officer, director, general partner, or manager. Further, the prior experience must be recent: the officer must currently be associated with the franchisor or have been associated with the franchisor within 60 days of the proposed franchise sale. For example:! An officer new to the company with only 14 months of experience would not qualify for the exemption. The officer must have two years of experience with the company to qualify.! An officer with five years of experience with the company who leaves the company on January 1, 2007, would not qualify for the exemption if she were to seek to purchase a franchise on July 1, The officer s prior experience must be within 60 days of the franchise sale. To take advantage of the exemption, an owner must also seek to purchase at least a 50% ownership interest in the franchise being offered for sale. In addition, the owner must have had at least a 25% interest in the franchisor for at least two years, and that ownership interest must be recent at least 60 days before the sale of the franchise. For example:! An owner of only a 10% interest in a company would not qualify for the insiders exemption if she were seeking to purchase a franchise. She must own at least 25% of the company to qualify.! An owner of a 50% interest in the company would not qualify for the exemption if he owned his interest for only eight months. To qualify, an owner, even if a sole stockholder, must own his interest for at least two years.! A sole stockholder of the company would not qualify for the exemption if she sells her shares in the company and then seeks to purchase a franchise eight months after the sale. The ownership interest must be recent within 60 days of the sale. -14-

25 Exclusions from the Amended Rule The following relationships are excluded from the amended Rule. Although each of these relationships may have some superficial similarities with a franchise relationship, none of them meet the definitional elements of the term franchise, and should not be confused with a franchise relationship.! Employer-Employee Relationship Exclusion Bona fide employer-employee relationships are excluded from coverage under the amended Rule. The Commission will apply the traditional test of right to control in determining whether an employment relationship exists. Specifically, in determining whether a bona fide employer-employee relationship exists, the Commission will consider: (1) whether the employer pays a salary or definite sum of money as consideration for the work; (2) whether the employee can be discharged or his employment terminated without liability on the part of the employer; and (3) whether the employee must invest money in the business before being hired. 8! General Partner Relationship Exclusion Bona fide relationships among general partners are excluded from coverage under the amended Rule. All partners in the partnership must be general partners to qualify for the exclusion. The Commission will look carefully at partnership arrangements that seek to exploit this exclusion by, for example, structuring a relationship to shield a limited partner (a de facto franchisor) from liability to the disadvantage of the general partner (a de facto franchisee). 8 Original Interpretive Guides, 44 Fed. Reg. at 49,

26 ! Cooperative Associations Exclusion Two types of cooperative associations qualify for this exclusion: (1) agricultural cooperatives authorized by the Capper-Volstead Act, 7 U.S.C. 291; and (2) retailerowned cooperative chains. Retailer-owned cooperatives are those operated by and for independent retailers on a cooperative basis. The members must be independent retailers, and the organization must furnish services or goods primarily to its members.! Certification or Testing Services Exclusion The amended Rule continues to exclude relationships that are created solely by arrangements with bona fide certification or testing services, such as are offered by Underwriters Laboratories and similar organizations. Franchising involves distribution of goods or services through selected outlets. In contrast, certification or testing services authorize use of their trademark by all parties meeting their standards and willing to pay their fee.! Single Trademark License Exclusion The amended Rule continues to exclude trademark licensing arrangements in which a single licensee is granted the right to use the trademark. This exclusion also includes a one-on-one licensing arrangement, i.e., the license of a trademark to a single licensee who manufactures the trademarked goods according to the licensor s specifications. This arrangement is common, for example, in the clothing industry where trademark owners license the manufacture of textiles. The exclusion also includes collateral product licensing, i.e., the practice of licensing a trademark that is well-known in one context (e.g., a soft drink logo) for use in another (e.g., on clothing or decorative items embossed with the soft drink logo). This exclusion also includes licensing agreements entered into in the course of settlement negotiations in trademark infringement litigation, when the licensor grants the infringing party a license to use the trademark for a specified period. -16-

27 DISCLOSURE COMPLIANCE OBLIGATIONS The Rule specifies who must prepare the disclosures, who must furnish them to prospective franchisees, how franchisees receive the disclosures, and how long franchisees must have to review the disclosures and any revisions to the standard franchise agreement. WHO IS RESPONSIBLE FOR PREPARING DISCLOSURE DOCUMENTS? Franchisors are responsible for preparing disclosure documents. The term franchisor means any person [including any individual, group, association, limited or general partnership, corporation or any other entity] who grants a franchise and participates in the franchise relationship. Both requirements are necessary. Accordingly, franchise sellers such as brokers who engage only in pre-sale activities but who have no post-sale relationship obligations are not franchisors under the amended Rule. Subfranchisors are also responsible for preparing disclosure documents. The term franchisor expressly includes subfranchisors. The term subfranchisor means a person [including any individual, group, association, limited or general partnership, corporation or any other entity] who functions as a franchisor by engaging in both pre-sale activities and post-sale performance. This term does not include a third-party broker with no post-sale performance obligations, even if called a subfranchisor. Both the franchisor and any subfranchisor are responsible for each other s compliance with the amended Rule and are jointly and severally liable for each other s violations. The franchisor and subfranchisor bear a joint responsibility under the Rule to ensure that required disclosures are made and are accurate. Some of the required disclosures may need to be supplied by the subfranchisor only or by the franchisor only. In other instances, both the franchisor and subfranchisor must supply the information so that the required disclosure is accurate. -17-

28 Generally, Items 1-4 (information about the franchise system, prior business experience, litigation, and bankruptcy) call for both the franchisor and subfranchisor to supply information. In addition, a subfranchisor must provide Item 20 information (franchisee and company-owned outlet data). The franchisor must also provide Item 20 information if its statistics differ materially from the subfranchisor s statistics. Finally, both the franchisor and any subfranchisor must include their own financial statements in Item 21. WHO IS RESPONSIBLE FOR FURNISHING DISCLOSURE DOCUMENTS? Franchisors (including any subfranchisors) are responsible for furnishing disclosure documents to each prospective franchisee. A prospective franchisee is any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship. Accordingly, franchisors do not have to furnish copies of their disclosure documents to members of the general public such as journalists, academicians, or those surfing online who hit upon a franchisor s website. A person must have some bona fide interest in becoming a franchisee, not mere curiosity. At the same time, franchisors may comply with the obligation to furnish disclosure documents to prospective franchisees though an agent or representative of a prospective franchisee, such as an attorney. In the case of a corporate prospect, disclosures can be furnished to a company officer. What Happens When an Existing Franchisee Sells His or Her Outlet? A transferee a person who purchases an existing franchise directly from the franchisee who owns it, without any significant contact with the franchisor is not a prospective franchisee. Even if the franchisor has, and exercises, the right to approve or disapprove a subsequent sale (transfer) of a franchised unit, the transferee will not be entitled to receive disclosures unless the franchisor plays some more significant role in the sale. For example, if the franchisor provides financial performance information to the prospective transferee, the franchisor would be required to provide the transferee with its disclosure document. -18-